Ecuador Default Stirs Fear of a Ripple Effect

Ecuador and its creditors are highly unlikely to reach an arrangement on restructuring the country's international bonds by the end of this month, and failure to do so could disrupt global financial markets.

At the heart of the problem are some $6 billion of so-called Brady bonds. Named for former Secretary of the Treasury Nicholas Brady, the bonds initially were issued in the late 1980s and early 1990s in a program to help emerging-market countries finance their debts to U.S. and other foreign banks.

The Ecuadoran government took over the foreign debt of its commercial banks and corporations and turned those loans into Brady bonds -- which it then used to repay its debts to the foreign banks. Banks accepted the bonds in place of the unpaid debt, taking a 45% loss on the loans' face value.

The deal was palatable to the lending banks because Ecuador collateralized the bonds with zero-coupon U.S. Treasury securities stored in the vaults of the Federal Reserve Bank of New York. But the zero-coupon Brady bonds do not reach their full value for another 25 years, and interest payments are not collateralized.

Until Ecuador's failure to make a $96 million payment due Tuesday, making timely payments on Brady bonds was considered sacrosanct.

Ecuador now has 30 days from the date of default to work out an agreement with holders of the bonds. That has become tricky because Ecuador is said to be asking the bondholders -- most of them U.S. and foreign banks -- to negotiate another reduction of its debt on top of the 45% haircut the banks took when the bonds were issued.

International finance experts fear that giving in to a new restructuring would encourage other countries to default. Venezuela is considered the most likely to do so, experts said. That could lead to a loss of confidence in Latin America and precipitate a new credit crunch as banks and capital markets refuse to provide fresh credit.

"You can only play this game so many times," said Elizabeth Morrissey, managing partner in Washington-based Kleiman International Consultants Inc. "Latin America cannot afford to be shut out of capital markets, but if they start trying to change the rules of the game again, they will be."

Ecuador's Brady bonds account for nearly half the country's $13 billion of foreign debt. Between 50% and 60% of them are held by U.S. and foreign banks, and many have been incorporated into a variety of derivatives contracts. The remainder are held by institutional and private investors.

"If they manage to reach an agreement, it'll be the fastest debt restructuring I've ever seen," said David Sekiguchi, vice president for emerging-market research at J.P. Morgan & Co.

In addition to bond holdings, U.S. banks also held $655 million of cross-border loans to Ecuador at the end of March, down sharply from $863 million at the end of December. The $208 million reduction was at least partly responsible for Ecuador's Brady bond default.

Bankers and analysts said several factors explain why agreeing on how to deal with the problem will not be easy.

For one thing, Ecuador's economy went into a tailspin this year after a series of natural disasters, as well as financial mismanagement that triggered the collapse of several major banks. As a result, its gross national product is expected to fall 7% this year, to about $14.5 billion, so finding the money it needs to service its debts will not be easy.

Another reason: In contrast to the late 1980s and early 1990s, when restructurings revolved around bank loans and were arranged with a handful of U.S., European, and Japanese banks, Ecuador now must negotiate with banks as well as hundreds of institutional investors. It is still not clear who will represent investors and whether any decision by the banks, or agreed on with multilateral lending agencies, will be accepted by those investors.

Lawyers representing Ecuador say the country needs approval from only 25% of its creditors to swing a deal. Investors have other views. They insist that any change in the original contracts require approval of every creditor.

"Before Ecuador comes to the market with proposals, it should try talking to the market first," said Marc Helie, managing director at Gramercy Advisors LLC, a New York investment management company that is trying to ensure that nonbank investors are included in any discussion between Ecuador and the banks.

"Otherwise, any proposal they bring will be dead on arrival," Mr. Helie warned.

Bankers and market sources said they have not received any formal proposal so far. According to the financial market grapevine, Ecuador wants bondholders to swap the existing bonds into new ones at a 30% discount and to give the country a one- to two-year grace period on repayments. It is also asking for elimination of any collateral, the sources said.